Our framework for blending returns

We believe investors need to distinguish between alpha, broad market and factor returns. This allows investors to allocate to genuine alpha opportunities within and across asset classes. And clarity on the sources of returns helps investors measure and understand their aggregated factor exposures while potentially sticking more closely to portfolio objectives by fully accounting for them. Looking at excess returns alone can be deceiving, so we see a need to uncover the factor exposures embedded in them.

A blend of returns should be based on investor objectives, constraints and practicalities. Blending alpha-seeking managers with indexing and factor strategies should occur at a whole-portfolio level rather than within asset class silos. Alpha-seeking strategies with higher expected alpha, net of fees, may entail higher risk. Yet we believe they should not be ruled out even if contributing meaningful market and factor exposures – provided those exposures are accounted for.

We believe what matters are returns net of costs. Yet product fees vary widely by client and over time. Governance costs to find and monitor alpha-seeking managers can also be considerable. Fees may lower returns – and alpha. Many investors have limited resources for these activities. Investors with a limited governance budget may opt to oversee just a few alpha-seeking managers – or even keep their entire portfolio in index products.

Macro and equity style factors are important drivers of returns, both through indexing products and alpha from timing factor returns. It is important to separate this source of return from any alpha-seeking manager’s excess return relative to a benchmark to understand the return being paid for.

Our work seeks to find not just factor-driven returns within excess returns, but also what we call common alpha – a return that appears factor-like but cannot be explained by current macro and style factors. We group this with pure alpha – alpha that can be explained by manager skill alone – for the purposes of attributing alpha.

What matters are returns net of costs. Product fees cut into returns and can reduce or, in some cases, eliminate the alpha an investor receives. Yet these fees vary widely and change over time. Some index products can also have large fees. Investors should fully account for fees in portfolio construction.

Governance costs – those required to find and manage alpha-seeking managers – are a key consideration. Because costs are negotiable and client specific, our framework for blending alpha and index looks at returns and costs separately.